Wednesday, 2 October 2013

Abandoning dichotomies in science

I have
recently published a couple of posts arguing against the de-politicisation of mathematics. These thoughts have emerged as I
have spent the summer investigating Pragmatic philosophy. I was
doing this as part of my primary aim of establishing an ethical basis
for Financial Economics.

The
problem I had to grapple with was what is known as the fact/value
dichotomy, which claims that there is a separation between what we
know and our ethical values. Clearly if I want to relate morality to
the mathematical science of Financial Economics, in particular my
field of Financial Mathematics, I need to abandon the fact/value
dichotomy yet remain within mainstream thinking. This can be done by
adopting Pragmatism, which is founded on the denial of the ‘spectator
theory of knowledge’, that we can stand back from what we observe
and, either through Empiricism or Cartesian Rationalism, identify
certain, objective truths. Having adopted this stance, Pragmatism
must navigate a difficult path between scepticism – nothing is
justified belief – and relativism – all beliefs can be justified.

As
a Financial Mathematician, Pragmatism has a number of attractive
features. It rejects the belief that we can be certain of anything,
which resonates with people involved in the markets, and under such
circumstances attempts to define how to act. As well as rejecting
the fact/value dichotomy, a strategy is to embrace pluralism, in the
context of finance this implies we should avoid investing in
super-portfolios; situations where distinct agents adopt identical
strategies so that there is no diversity in the market. Another is
to reject a dichotomy between means and ends, this is an emergent
theme in financial mathematics manifested as ‘forward utility’
functions. Finally I am very interested in Pragmatic views that
knowledge is all about communication: we have ideas about
‘something’, but this does not make our ideas knowledge, our
ideas need to be confirmed/denied with reference to a third party’s
ideas about the ‘thing’. On this basis ‘communicative action’
becomes essential to society. I think there are links between
theories of ‘communicative action’ and ideas of how markets
should operate, so they are seen as positive aspects of society, not
destructive.

In
arguing that mathematics should be politicised I take my self out of
orthodox views that scientists should aim to be ‘honest brokers’,
presenting policy makers with options that they can choose.
Pragmatism is emphatic in stating that scientists are not able to be
‘honest brokers’. Given that scientists cannot provide objective
assessments, of climate change for example, I think Pragmatism argues
that we should engage in rational discourse that does not involve
insincerity (hiding things) and dogma (rejecting hypothesis out
of hand). With regard to the topical discussion of climate science I
think this piece gets to the heart of the matter: the IPCC is looking
for consensus, as a result it attempts to silence dissent, rather
than ‘honestly’ addressing the concerns of anyone who might
disagree with its arguments.

I
am still working towards my primary objective, which has morphed into
establishing that the norm of reciprocity is the foundation of
Financial Economics. I will post the four sections of the argument
(with some enhancements) over the next few weeks. The full paper is
on SSRN and I genuinely welcome constructive comments

1
Introduction

The processes of structured finance employing ‘special purpose
vehicles/ structured investment vehicles’ (SPVs / SIVs) to fund
activities, whether by industrial corporations, like Enron;
governments, such as the UK government’s Private Finance
Initiative; or banks, through asset backed securities, has had a
significant impact on modern business practice. However, along side
its growth, structured finance has become associated with financial
crises, particularly the Financial Crisis of 2007—2009 ([14],
[9], [1]).
Recurring themes associate the Crisis with financial innovation
generating complex risks (e.g. [20,
p 55], [17, p 564], [52,
p 769], [80, p 14]) and the
inability of the mathematical techniques employed by financial
economics to address these issues (e.g. [10],
[20], [17],
[80, p 14], [52],
[16], [40],
[25]). Amongst those who
identify a problem with mathematics, there are two classes: those who
can see a possible solution in mathematics (e.g. [10],
[16], [40])
and those who don’t and advocate tighter market regulation (e.g.
[20], [17],
[52], [80]).

While SPVs are frequently presented as twentieth century innovations,
their fundamental character of transforming an uncertain future
cashflow into a fixed and insured cashflow was exhibited in the
ContractusTrinus (the ‘triple’ or ‘German’
contract). [63, Ch 10] and [22]
have given detailed accounts of the contract and the scholastic
debate about their legitimacy which eventually led to their
condemnation of usury in 1586 (Detestabilia avaritia).
Securitisation and collateralisation manifested themselves as the
corpo/sopracorpo structures that emerged in the thirteenth century
(e.g. [65, p 554]) and the
trading of securitised assets has been widespread since the
eighteenth century, particularly through the reinsurance markets
(e.g. [54, p 38]).

Mathematics is frequently presented as being an alien encroaching
into economics (e.g. [84]).
However the foundation of European mathematics is in Fibonacci’s
1202 Liber Abaci, a text for merchants [75],
and the subsequent mathematisation of the physical sciences was
stimulated by the mathematical analysis of financial phenomena (e.g.
[39], [47]).
The emergence of mathematical probability, at the heart of all
science, is out of the ethical analysis of commercial contracts (e.g.
[32], [77],
[8], [78]).
Rather than mathematics encroaching on economics, the historical
account suggests that economics has generated mathematics that is
then used in other domains. The issues that many of the critics of
the contemporary use of mathematics in economics raise are not
relevant to mathematics, as conducted throughout history, but to
modern mathematics. The nature of mathematics has changed in the
twentieth century; pre-modern mathematics developed in the vernacular
of financial practice and between the eighteenth and twentieth
centuries was motivated by observation of natural phenomena. In the
second half of twentieth century a theoretical,
formalist-deductivist, approach dominated mathematics, and this was
adopted by orthodox economics. While this approach to mathematics has
been rejected in the physical sciences [35]
it seems to persist in economics (e.g. [84],
[53, Ch 10]).

This sketch suggests that while financial technology has not changed
significantly over the centuries, attitudes to risk-taking and
mathematical practice have. Contemporary attitudes to risk-taking and
mathematical approaches to financial problems before the nineteenth
century have the common feature of being explicitly ethical.
Authoritative assessments of the causes of The Crisis that have
looked beyond the field of economics have focussed on the ethical
nature of the financial failures. The Financial Crisis Inquiry
Commission (FCIC) concluded that in the lead up to The Crisis there
had been a “systemic breakdown in accountability and ethics”
[26]. The UK’s Parliamentary
Commission on Banking Standards [67]
pointedly titled their comprehensive report of 2013 “Changing
Banking for Good”, emphasising that the direction of change should
be in an explicitly moral direction. The argument in both reports is
that improving ethical behaviour is a key component of improving
financial stability. The role of mathematics is peripheral but
significant in that it legitimised financial innovation by creating a
false sense of confidence (e.g. [26,
p 44], [67, vol. 2, para. 60]):
mathematics speaks with an indubitable authority that need not be
questioned [53, Ch 10].

In light of these observations the purpose of these articles is to
investigate links between contemporary financial economics and ethics
in order to make a contribution to mitigating financial crises. This
theme has been addressed by a variety of authors, for example, Kevin
Jackson [45] tackles it
tangentially by addressing failures in the curricula of Business
Schools, an issued examined in detail by Jason West [85].
Pre-dating the events of 2007, James Horrigan, George Frankfurter and
Elton McGoun have examined the underlying ideology of financial
economics ([44], [31],
[30]).

The relative paucity of literature on ethics in financial economics,
as compared to scholarship on ethics in other technology based
professions, probably comes about because the discipline is
explicitly mathematical and mathematics strives to be infallible by
maintaining a strict fact/value dichotomy. Therefore, in order to
achieve its objective the paper will abandon the fact/value dichotomy
in financial economics. This path is justified by adopting a
Pragmatic approach, which is characterised by arguing that knowledge
has no certain, infallible, foundations and because scientists are
part of the system they observe, there can be no real distinction
between what is and what ought to be. A consequence of adopting a
Pragmatic approach is that the historical evolution of beliefs and
the role that practice has in generating theory are an important
themes running through the paper. [59,
Introduction]

Pragmatism addresses the question of ‘what is’; the ‘fact’,
the paper addresses ‘what ought to be’; the ‘value’, by
taking a Virtue Ethics approach, as employed in the seventeenth and
eighteenth centuries and is a growing area of interest (e.g. [28]).

As a consequence of taking this approach is that this paper concludes
that contemporary financial economics has an implicit foundation in
ethics, specifically Justice expressed as balanced reciprocity. This
is the central argument of the paper. This conclusion is arrived at
by showing that one of the fundamental theory of financial economics,
the Fundamental Theorem of Asset Pricing (hereafter ‘FTAP’), has
its basis in the virtue ‘Justice’. The FTAP is the mathematical
theory underpinning modelling frameworks such as
Black-Scholes-Merton, Cox-Ross-Rubinstein, Heath-Jarrow-Morton and
the LIBOR Market Models and is the central theory in contemporary
mathematical approaches to pricing derivatives. Its significance is
in unifying various strands in financial economics: Samuelson and
Merton’s use of stochastic calculus; CAPM, developed by Treynor and
Sharpe; martingales, employed by Fama in the development of the
Efficient Markets Hypothesis; Arrow and Debreu’s concept of
incomplete markets and in accomplishing this unification it
represents a Kuhnian paradigm for financial economics.

Arguing that virtue ethics are implicit and embedded in contemporary
financial economics is unorthodox; it is more normal to argue that
markets are socially destructive (e.g. [50],
[72] ) or have the potential
for corruption if not constrained (e.g. [20,
p 55], [17, p 564], [52,
p 769], [80, p 14]), and so
financial economics is immoral in facilitating this corruption. These
attitudes have a powerful influence on how investigations of the
causes of The Crises are framed. In order to address these framing
issues, we discus the changing social attitudes to markets in order
to provide some context to the thesis that financial economics is
implicitly ethical.

2 Fact

Determining what is is part of epistemology, and
epistemological theories can be broadly separated into two classes,
foundational and coherentist. “Foundational theories
attempt to ground knowledge in a solid base such as sense experience
[Empiricism] or a priori reasoning [Realism]. In contrast,
coherentists argue that there are no foundations for our beliefs,
whose justification derives from how well they fit together with each
other.”[79]

Realism argues that there is an ‘intelligible’ universe, of
immutable truths, and a ‘sensible’ universe, that is actually
experienced and undergoes change. ‘Truth’ transcends experience
and can be established only through abstract thinking (Rationality).
Realism, in the Christian and Islamic traditions, can be traced to
Plato’s Theory of Forms (or Ideals) and was central to Descartes’
and Kant’s philosophy. In this framework, there is a hierarchy of
knowledge with mathematics being closer to ‘truth’ than
experimentation. Beliefs in the immutability and indubitability of
mathematics became embedded in western philosophy with the
Neo-Platonists, such as Augustine of Hippo, who associated
mathematics with a transcendental deity [5,
p 46].

Contemporary Empiricism argues that there are two types of truth:
tautologies, established through formal mathematics or logic; and
factual statements that can be verified by employing the ‘scientific
method’ to guide observation and analysis. A principal of
Empiricism is that while ‘Truth’ might be unachievable, the
scientific method will converge towards a close approximation of true
facts. European Empiricism has its roots in Greek Epicureanism and
became dominant in British philosophy through Francis Bacon, John
Locke, David Hume and J. S. Mill. Logical Positivism, a form of
Empiricism, emerged in Vienna in the early twentieth century and
became significant in North America in the 1940s.

While Empiricists reject the metaphysics of Realism, they generally
do not challenge the status of mathematics and created a special
class of truth related to Hilbert’s Formalism. To appreciate the
distinction between Realism and Empiricism, a Realist might claim
that “2 + 2 = 4 was true at the time of the dinosaurs”, implying
the mathematics is independent of human thought (synthetic a
priori); an Empiricist would claim the statement is a tautology:
2 := 1 + 1,4 := 1 + 1 + 1 + 1 and so 2 + 2 = (1 + 1) + (1 + 1)
= 4 (analytic a posterior).

Realism and Empiricism are foundational theories built on the idea
that ‘Truth’ is a static relationship to some reality that is
external to the thinker. Pragmatism, on the other hand, argues that
‘Truth’ is just what ‘competent, rational enquiry’ produces.
Pragmatism emerged in the late nineteenth century with Charles
Peirce, William James and John Dewey and developed more recently by
Richard Rorty, Hilary Putnam and Robert Brandom, amongst others.
While closely associated with American philosophy, there have been
Pragmatic strands in French thought, associated with Greek Sophism,
notably the ‘occasional Pragmatism’ of Henri Poincaré [42]
while Émile Durkheim acknowledged the usefulness of Pragmatism in
destroying “the cult of truth” ([51],
[24, pp 69-72]). In Britain,
Pragmatism has been associated with the Cambridge School,
particularly with (the later) Wittgenstein and Huw Price. Pragmatism
overlaps Empiricism (e.g. Peirce, Quine) and Realism (e.g. Brandom,
Putnam) [73, pp xvi—xvii].

Pragmatism does not assign a special status to mathematics, in the
way that Realism and Empiricism do, Putnam argues that

we learn what mathematical truth is by learning the practices and
standards of mathematics itself, including the practices of applying
mathematics. [70, p 66]

while Poincaré observed that

The principal aim of mathematical education is to develop certain
faculties of the mind, and among these intuition is not the least
precious. It is through it that the mathematical world remains in
touch with the real world, and even if pure mathematics could do
without it, we should still have to have recourse to it to fill up
the gulf that separates the symbol from reality. [68,
p 449]

[The
definition of ‘intuition’ here can be read as ‘The action of
looking upon or into; contemplation; inspection; a
sight or view.’ (OED 1), from the Latin intuitus:
to look, rather than the philosophical definition ‘The immediate
apprehension
of an object by the mind without the intervention of any reasoning
process’ (OED 3).]

Pragmatism is being associated with a revival of ‘classical
economics’ [56], is close to
Pasinetti’s description of the Cambridge School of Keynesian
Economics [66], relates to
Deirdre McCloskey’s economics founded on rhetoric (discourse) [57],
has been linked to behavioural economics [49]
and institutional economics [7].
Pragmatic approaches are distinguished by acknowledging ethical
features of economic behaviour and emphasising the role of
uncertainty ([46], [23]).
For example, Friedman’s argument in The Methodology of Positive
Economics appears to share principles of Pragmatism [49,
p 2]: “[Positive economics’] performance is to be judged by the
precision, scope, and conformity with experience” [34,
p 4]. However, Friedman’s rejection of a normative dimension to
economics and a faith in the ability to verify stable economic
theories makes it incompatible with Pragmatism.

3
Value

Ethical frameworks, in the Western tradition, are usually classed as
being Deontological, Consequentialist or Virtuous. Deontology can be
typified as “Thou shalt / shalt not” and guides action on
the basis of laws, rules or principles. Since an individual cannot be
subject to a law unless it has been promulgated, Deontology is linked
to with philosophical systems that are based on ‘divine’ or
‘natural’ law, such as Realism and Stoicism [3,
p 14]. The practical problem with Deontological Ethics is that basic
rules such as “Thou shalt not kill” have caveats while other
prohibitions become redundant, or need revising, as society evolves.
In the context of contemporary economics, Deontological Ethics has
been employed in financial regulation (e.g. Pillars I & II of
Basel II) and has been criticised for being over-bureaucratic and
rigid while susceptible to ‘gaming’; adhering to the letter of
the law but not the spirit. [82,
pp 23—26]

Consequentialism attempts to judge the value of an action in terms of
its consequences. This approach has its roots in ancient Chinese
Mohism and Greek Epicureanism, developed in opposition to Platonism
and Stoicism. The approach became fully developed in the nineteenth
century with a trio of British philosophers, Bentham, Mill and
Sedgewick, who argued that one should “Act always in such a way as
to promote the greatest happiness to the greatest number”.

On the basis of Consequentialism and David Hume’s distinction of
‘what is’ and ‘what ought to be’, ‘value—neutrality’
was established in economics: since we have ‘objective access’ to
the empirical world’ and are ‘rational beings’, we are able to
calculate the consequences of our economic actions [86].
A problem with this value-neutrality, described by Robert Heilbroner,
is that it misses the critical fact that

the objects observed by the social scientist all possess an attribute
that is lacking in the objects of natural universe. This is the
attribute of consciousness — of cognition, of “calculation”, of
volition [41, p 133]

The importance of ‘volition’ had been recognised by Oskar
Morgenstern, who objected to perfect foresight based on calculation
because

always there is exhibited an endless chain of reciprocally
conjectural reactions and counter-reactions. This chain can never be
broken by an act of knowledge but always through an arbitrary act —
a resolution. [58, quoting
Mogernstern on p 129]

Practically this means that while we could incorporate the
possibility of a Japanese earthquake into the modelling of asset
prices, it would be impossible to account for the behaviour of Nick
Leeson in destroying Barings’ Bank.

As well as questioning the basic ability to predict in a social
context, Consequentialism has been criticised because obviously
immoral acts, such as the execution of the innocent, could be
justified either by the hope of good consequences or the fear of bad
[3, p 14]. In response to these
problems, many argue that ethics should focus on the judgement of the
agent taking the action that has consequences, or Virtue Ethics.

Virtue Ethics, in the European tradition, is associated with
Aristotle, in particular Nicomachean Ethics in which virtues
are the “characteristics that enable individuals to live well in
communities” [69, p 247].
Aristotle’s ethics do not distinguish reason and emotion, as Hume
did in the eighteenth century, nor do they define absolute standards,
rather Virtue is a consequence of personal reflection [81,
pp 6—8]. This opens Virtue Ethics to the criticism that it cannot
be codified into a set of rules that any person could apply to
determine ethical action in any situation. However, this criticism
assumes such a reduction is possible, and implicit in this is that
the environment is stable and predictable. The advantage of Virtue
Ethics is precisely that it can accommodate unforeseen circumstances.

Virtue Ethics is often associated with Catholicism, the four
‘Cardinal’ virtues; Courage; Justice; Temperance; and Prudence,
and three, so-called, ‘Christian’ virtues: Faith; Hope; and
Charity, however all these virtues existed in pre-Christian Greek and
Roman philosophy, which influenced both Judaic and Islamic thought.
Chinese (e.g. [83]) and
Indian philosophy both have their own versions of Virtue Ethics that
can be mapped onto the European framework. Particularly relevant is
the first century Mahayana Buddhist Vimalakirti Sutra that
tells the story of how a virtuous merchant instructs both kings and
monks.

While it is conventional to associate Deontology with Realism and
Consequentialism with Empiricism, it is not so well established to
associate Virtue Ethics with Pragmatism, but there are links, notably
through John Dewey [15] and in
the discussion of reciprocity [64].
More broadly, Aristotle argued that excellence of character [ethike]
derives from ‘habituation’ [ěthos]
[13, 1103a15—20]. This can
be related to the technical term ‘Pragmatism’, which is derived
from the Greek word describing ‘deed, act, affair, matter,
business’ [pragma] and both words are more closely
associated with ‘practice’ than ‘theory’.

With these observations in mind, Khalil makes the point that “true
[Pragmatic] inquiry cannot take place in an ivory tower” [49,
p 2] and discourse is central to Pragmatism. Putnam admires Jürgen
Habermas’ position on ‘communicative action’. Habermas defines
a ‘norm’ as a “universally valid statement of obligation”,
which some might equate with a ‘virtue’, where as a ‘values’
are culturally specific. The “binding universal norm” is
‘communicative action’, “norms of communication governed by the
ideal of rational discourse” and the ideal of rational discourse is
governed by

the norm of sincerity, the norm of truth-telling, and
the norm of asserting only what is rationally warranted ...
[and] is contrasted with manipulation. [71,
pp 113-114]

While Putnam is describing society in general, these ‘virtues’
could well apply to guiding financial markets in particular.

Putnam observes that the problem of leading an ethical life is a fact
of life that cannot be solved ex cathedra, by philosophy
external to the individual such as with Deontology and
Consequentialism. Rather, ethical disagreements are resolved through
‘communicative action’ in a social context and the norms that
govern this ‘communicative action’ have the features of ‘virtues’
(i.e. tempering, justice, faith, charity and prudence). However, in
advocating pluralism Pragmatism, like Virtue Ethics, has to defend
itself from the criticism of Relativism (e.g. [73],
[55, p 53], [27]).

4 The
Morality of Markets

Albert Hirschman has provided a description of four different views
on the relationship between markets and morality: doux-commerce,
self-destruction, feudal-shackles and feudal-benefits [43].
The idea that commerce improved society was prevalent throughout the
eighteenth century. In 1704 technical text on commerce argues
“Commerce attaches [men] to one another through mutual utility”;
while in The Rights of Man (1792) Thomas Paine writes
“[Commerce is a pacific system, operating to cordialise mankind”.
In the intervening years Montesquieu, Hume, Condorcet and Adam Smith
all agreed that commerce was a powerful civilising agent, promoting
honesty, industriousness, probity, punctuality, and frugality, in
contrast to the excesses of absolute monarchies.

Following the Industrial Revolution, these attitudes all but
disappeared and were replaced by views that blamed the collapse of
morality on the influence of capitalism. Commerce was seen as
commodifying human interaction, “custom is replaced by contract”,
and on this basis Romantics saw capitalism as being un-natural and
undermined traditional hierarchies while Marxists believed that
commerce’s alienation of the proletariat along with capitalism’s
instabilities would lead to revolution. Others believed that the
success of capitalism, founded on frugality and probity, would be so
great that society would eventually become dissolute, seeking instant
gratification, echoing the rise of Republican Rome and the fall of
Imperial Rome.

Both the doux and self-destructive views of commerce
represented capitalism as a powerful force driving social change.
When capitalism did not collapse, the emphasis changed and capitalism
was not seen as strong but weak: the bourgeoisie were unable to
escape traditional social forces. The United States of America, not
bound by “feudal—shackles” seemed to have an advantage over
Europe between 1914 and the sixties. Capitalism, led by America,
seemed to rediscover its confidence in solving society’s problems
after the Second World War. But this confidence was lost in the
economic malaise of the seventies. Because America did not have the
feudal past of Europe it did not have social and ideological
diversity and so reforms, such as Roosevelt’s New Deal, were
vulnerable to a “tyranny of the majority”; America missed the
feudal—blessings. Daniel Friedman has recently presented the
relationship between markets and morals as a difficult marriage:
“where markets sabotaged morals, and morals hurt markets” [33,
p 4]. In the aftermath of The Crisis, and of particular interest to
this project, Johan Graafland has related contemporary economic
literature to the doux-commerce and self-destruction theses in
the context of Aristotelian Virtue Ethics [36].

Marion Fourcade and Kieran Healy [29]
have recently returned to Hirschman’s characterisation and argue
that it is still valid today, but have added a fifth
characterisation: Moralized Markets. In their paper Fourcade and
Healy identify the four strands of Hirschman’s thesis in recent
scholarship starting with doux-commerce summarising Deirdre
McCloskey’s argument that markets nurture “bourgeois virtues”
as

Commerce teaches ethics mainly through its communicative dimension,
that is, by promoting conversations among equals and exchange between
strangers. [29, p 287]

Researchers performing empirical studies on the Ultimatum Game
(introduced the year of Hirschman’s thesis, by [38]),
argue that commerce fosters co-operation, particularity amongst
strangers while others support Hayek’s argument that “Capitalism
makes you free”. Finally, some economists look for evidence that
markets are the best motor for innovation. In opposition to these
strands, economists are arguing that instead of virtue we have envy,
instead of co-operation there is coercion, freedom does not equate to
populism and creativity is being stifled by copyright.

While economists seem to focus on the robust nature of markets, able
to create or destroy society, sociologists tend to study the
feebleness of markets. Following Weber, some authors argue that
markets are consequences of cultural legacy, of institutions. The new
Moralized Markets thesis goes further, it characterises markets as
‘cultures’, not simply a consequence of culture, which “are
explicitly moral projects, saturated with normativity.” [29,
pp 299-300].

Fourcade and Healy identify three strands of the Moralized Markets
thesis. Firstly, there is the view that markets have a role in
creating moral boundaries, as McCloskey argues. This approach follows
Durkheim, who argued that morality is not fixed by some ‘Ontological’
ethical standard (that is, one fixed and derived from a single issue
[70, p 19]); rather, morality
is defined by the group.

The second strand builds on the first by turning to the sociology of
science, where an emphasis is placed on impartiality in evaluating
scientific knowledge (i.e. it studies failures as well as successes).
A key theme in this approach is to study what Michael Callon called
the ‘performativity of markets’, that economic theory drives
economic behaviour, rather than economic theory describes
economic behaviour, in the words of Donald MacKenzie, financial
economics is “An engine not a camera”. These views are close to
the Pragmatic attitude, that Empiricism and Rationalism fail by not
acknowledging that scientists are an active part of the system they
observe [6, pp 35—37, 50—53].

While the second strand of the Moralized Markets thesis focuses on
behaviour at the micro level, the third strand considers economic
rules at the macro level and how they are saturated with normative
considerations. For example, when Friedman made the case for positive
economics it was “to make correct predictions” [34,
p 4] he ignored the question of what determines ‘correct’, and
this driven by mutable normative values. For example determining
‘correctness’ has changed with the emergence of the value
‘efficiency’ and the decline of ‘social cohesion’.

5 The Morality of
Gambling

Gambling is today regarded as profane, but this was not always the
case. For the Greeks, the brothers Zeus, Poseidon and Hades cast lots
to divide up the universe. The Hindus believe the world was a game of
dice played between Shiva and his wife and at the heart of the epic
tale Mahabharata is an, unfair, dice game between the Kauravas
and the Pandavas.([74, p 27],
[11, p 1—5]). Divination by
casting lots played an important role in Judaism and the Bible refers
to the ‘judgement’ of Urim and Thurim, which
scholars today think were two dice ( Exodus 28:30, Leviticus
27:20-21, Samuel I 14:41 see [11,
p 2]).

Gambling was often associated with sacrificial practises that were
widespread and are generally known by their Native American name,
potlach. Potlach involved the destruction of goods, and seems
to have evolved in nomadic groups because they could not store what
was not needed and gambling was a means avoiding waste by
re-distributing goods before any excess was destroyed. Similar
ceremonies are described in Vedic scriptures ([48,
pp17-19], [37, p 56]).

The role gambling plays in archaic societies has been studied by Jon
Altman and William Mitchell. Altman studied an Australian aboriginal
group around 1980 [2]. The
community had access to social security payments and there was often
a surplus left over after essentials had been bought. However, some
individuals were excluded from social security payments by the
government and there was an “inter—household variability in
access to cash”. This variability was seen as a subjective
discrimination within the community by the Australian government and
gambling “acted effectively to both redistribute cash ... [and]
provided a means for people with no access income to gain cash” [2,
pp 60-61]. This was important in non-hierarchical communities because
it meant that one arbitrary bestowal of money was not corrected by
another subjective distribution, such as redistribution by a chief.
William Mitchell has considered the role that gambling plays in
disrupting hierarchical social structures, such as the Indian caste
system, by studying the Wape in New Guinea [60].
The conclusion was that the non-hierarchical society of the Wape was
maintained through gambling.

The pervasive nature of gambling in archaic communities, appearing in
the Vedic scriptures, potlach ceremonies, aboriginal Australia and
New Guinea and the Hazda [74, p
27] can be explained because it is an objective, ‘fair’,
mechanism for the redistribution of wealth. What needs to be
recognised is that this process remains valid only so long as no
single entity accumulates enough wealth that it can bankrupt all the
others.

Gambling had been outlawed in the medieval period, usually because
time spent gambling could be better used [11,
p 58]. However, building on Roman practice, lotteries began to be
used as means of raising public-finance in the later Medieval period.
The first private lottery appeared in the sixteenth century in Italy
and the mechanism spread to France and England [12,
pp 133—138]. The practice culminated in The Million Adventure
lottery set up by the English government and drawn in November 1694
[61, p 34].

The seventeenth century economist, William Petty, observed that
lotteries were “a tax upon unfortunate, self-conceited fools” and
from the start of the eighteenth century gambling became increasingly
associated with “the waste of time and money; the neglect of
familial and business duties; the erosion of social trust; and the
severed link between hard work, talent and gain.” [19,
p 161]. However, by the end of the century ‘gambling’, in the
form of insurance, had become a legitimate practice if based on
rational foundations ([87],
[18]) and in 1774 the Life
Assurance Act distinguished between legitimate insurance and illicit
gambling and became known as the Gambling Act.

Gabrielle and Reuven Brenner argue that the de-legitimisation of
lotteries, and gambling in general, comes about because during the
seventeenth and eighteenth centuries there was significant social and
economic change. In this environment gambling and speculation
provided the unlanded with a means to climb up the social ladder [12,
pp 98—104]. While the lotteries enabled this disruptive social
mobility, they were also a necessary tool of public finance that
prevented the stagnation and crises suffered by states reliant on
taxation [62]. By the start of
the nineteenth century, finance had developed to such an extent that
governments could tax more effectively, notably the incomes of the
middle classes, and borrow from the middle and upper classes, notably
by regulating and employing the life-insurance industry.

The prohibitions on gambling had an important impact on the
development of finance. In 1851, following a dispute between two
counterparties in a forward contract, English law established that
there needed to be ‘intent to deliver’ for a derivative to avoid
being classed as an illegitimate gamble [76,
pp 211—213]. While English courts avoided becoming involved in
derivative markets, U.S. courts were much more active in restricting
speculative behaviour and were vigorous in prosecuting “idlers who
made profit even while they slept” [21,
p 62, quoting Fabian]. One case, brought by the Chicago Board of
Trade (CBOT)against Christie-Street Commission Company, which was
offering its customers bets on the grain futures prices published by
the CBOT, eventually reached the U. S. Supreme Court, who ruled in
1905 that

People will endeavour to forecast the future, and to make agreements
according to their prophecy. Speculation of this kind by competent
men is the self—adjustment of society to the probable. [21,
p 71]

[14] G. Caprio, A. Demirgüç-Kunt, and E. J. Kane. The 2007
meltdown in structured securitization—searching for lessons not
scapegoats. Technical Report Policy Research Working Paper 4756, The
World Bank Development Research Group, 2008.

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About Me

I am a Lecturer in Financial Mathematics at Heriot-Watt University in Edinburgh. Heriot-Watt was the first UK university to offer degrees in Actuarial Science and Financial Mathematics and is a leading UK research centre in the fields.

Between 2006-2011 I was the UK Research Council's Academic Fellow in Financial Mathematics and was involved in informing policy makers of mathematical aspects of the Credit Crisis.